What’s next for European equities: Energy or ennui?

For the last few months, investors have tended to glaze over when we’ve spoken to them about European markets. It’s as though they never really believed risk had been set aside. They seemed to be looking for a reason to direct money elsewhere. Since February, they’ve found plenty. Is it time they changed their minds?

Massive outflows from European equities for the last three months (€m)

Populism, politics & pitfalls

Events in Italy are the latest reminder to the EU that populism may have been down but it was never out. The “Contract for a government of change” – the deal under which the anti-establishment Five Star Movement and the far-right League parties will work together – is high on aspiration and low on detail. What is clear is that their spending ambitions and their stance on immigration are a challenge for EU mandarins. It’s a question of who’ll blink first. Meanwhile, the separatist situation in Catalonia, though quiet, remains unresolved and sentiment on Spanish markets has yet to recover from the rejection of Rajoy

Voting with their feet:

IBEX & MIB returns & flows (local currency) Combined YTD Outflows

Source: Returns from Thomson Reuters Datastream & Lyxor International Asset Management as at 22 June 2018, in local currency. Flows data from 01/06/2017 to 01/06/2018, sourced from Bloomberg & Lyxor ETF Research Team. Past performance is no guide to future returns

At the same time, Brexit casts a long shadow. On the mainland, it may look like a domestic problem over the channel but to international investors it looks like the continent is splintering rather than drifting apart. Expect UK growth to remain under pressure and inflation prints to challenge BoE targets in the coming months.

Temporary troubles

The turmoil by the Tiber and the idiosyncratic troubles of some sectors like financials and exporters hampered European equities briefly, but they then rallied quite strongly before falling back again. Inflows resumed, albeit tentatively, but outflows are now back in force. So what’s next?

In our view, prospects for the euro area economy still look good, given domestic impetus. Companies are reporting labour and equipment constraints, but no slackening of demand. They are producing at full capacity, and corporate capex is increasing in most countries.

We therefore expect to see some evidence of a catch-up in the Q2 data and believe GDP should grow by 2% this year and a little less next year. The ECB still plans to turn the QE tap off by year end, as long as contagion risk from Italy is contained and real data displays some resilience.

The bank has also confirmed it’s unlikely to raise interest rates until we’re through the summer of next year at least, keeping the euro and bund yields anchored for now. A weaker euro should support exports, inflation and, ultimately, the ECB’s exit stance. Some sector and country selectivity could prove rewarding in this environment.

Your economic zone needs you

To date, the eurozone’s consumers have contributed little to the economic recovery. As the job market strengthens, we expect them to play their part by spending more across the region. Signs of wage growth in some countries are to be welcomed.

Digging deeper

There has long been a marked difference between the valuations of European markets and their US peers but the gap has narrowed. There may still be some limited upside from here, despite the politics, but the key catalysts (sales growth, margin recovery and so on) no longer have the energy they once did.

A more successful strategy may therefore involve digging a bit deeper. We’re still advocates of core markets like the CAC and DAX over peripheral peers like the FTSE MIB and IBEX because of stronger domestic growth, better political visibility and far better corporate balance sheets. The CAC in particular acts as a reasonable proxy for eurozone recovery. It has a decent mix of domestic and international exposures and positive long-term reforms are under way. Greek equities may offer some short-term opportunities as well with a form of debt relief now agreed.

We favour pro-domestic, cyclical sectors like consumer discretionary or construction and materials because their earnings profiles should improve as the region recovers, household spending picks up and real estate prices rise. We are avoiding expensive defensive sectors with low earnings growth prospects, particularly consumer staples.

Why choose Lyxor for Europe?

Whatever your view on Europe, we believe we have an investment to match. Our 60+ routes to the market include some of Europe’s lowest cost Core equity ETFs, with TERS from just 0.07%. Opportunity seekers can choose between some of the oldest and largest broad or single country equity exposures on the market or dig deeper into our 19-strong sector range – several of which rank amongst the best-performing and most liquid you can find. If regional recovery is front of mind, you could look to our MSCI EMU Small Cap ETF – the best performer in Europe – or single out one of our unique country-focused mid-cap funds.*

All views and opinion: Lyxor International Asset Management & Lyxor Cross Asset Research team as at 29 June 2018.

*Efficiency data over one year as at 31/01/2018. Past performance is no guide to future returns. Efficiency data is based on the efficiency indicator created by Lyxor ‘s research department in 2013. It examines 3 components of performance: tracking error, liquidity and spread purchase/sale. Each peer group includes the relevant Lyxor ETF share-class and the 4 largest ETF share-classes issued by other providers, representing market-share of at least 5% on the relative index. ETF sizes are considered as an average of AUM levels observed over the relevant time period. Detailed methodology may be found in the paper ‘Measuring Performance of Exchange Traded Funds’ by Marlène Hassine and Thierry Roncalli. Statements refer to European ETF market. Past performance is no guide to future returns.

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